1. Introduction to Production and Resource Use Chapter 6

2. Topics of Discussion Conditions of perfect competition Classification of inputs Important production relationships (assume one variable input in this chapter) Assessing short run business costs Economics of short run decisions

3. Conditions for Perfect Competition Homogeneous products No barriers to entry or exit Large number of sellers Perfect information Page 109

4. Classification of Inputs Land: includes renewable (forests) and non- renewable (minerals) resources Labor: all owner and hired labor services, excluding management Capital: manufactured goods such as fuel, chemicals, tractors and buildings Management: production decisions designed to achieve specific economic goal Page 110

5. Production Function Output = f(labor | capital, land, and management) Start with one variable input Start with one variable input Page 112

6. Production Function Output = f(labor | capital, land, and management) Start with one variable input Start with one variable input assume all other inputs fixed at their current levels… assume all other inputs fixed at their current levels… Page 112

7. Coordinates of input and output on the TPP curve Coordinates of input and output on the TPP curve Page 112

8. Page 113 Total Physical Product (TPP) Curve Variable input

9. Law of Diminishing Marginal Returns “As successive units of a variable input are added to a production process with the other inputs held constant, the marginal physical product (MPP) eventually declines” Page 113

10. Other Physical Relationships The following derivations of the TPP curve play An important role in decision-making: Marginal Physical =  Output ÷  Input Product Pages 114-115

11. Other Physical Relationships The following derivations of the TPP curve play An important role in decision-making: Marginal Physical =  Output ÷  Input Product Average Physical = Output ÷ Input Product Pages 114-115

12. Change in output as you increase inputs Change in output as you increase inputs Page 112

13. Page 113 Total Physical Product (TPP) Curve  output  input Marginal physical product is.45 as labor is increased from 16 to 20

14. Page 112 Output per unit input use Output per unit input use

15. Page 113 Total Physical Product (TPP) Curve output input Average physical product is.31 if labor use is 26 Average physical product is.31 if labor use is 26

16. Plotting the MPP curve Page 114 Change in output associated with a change in inputs Change in output associated with a change in inputs

17. Marginal Physcial Product Page 114 Change from point A to point B on the production function is an MPP of 0.33

18. Page 114 Plotting the APP Curve Level of output divided by the level of input use Level of output divided by the level of input use

19. Page 114 Average Physical Product Output divided by labor use is equal to 0.19 Output divided by labor use is equal to 0.19

20. Page 114 Three Stages of Production Average physical product (yield) is increasing in Stage I Average physical product (yield) is increasing in Stage I

21. Page 114 Three Stages of Production Marginal physical product falls below the average physical product in Stage II Marginal physical product falls below the average physical product in Stage II

22. Page 114 Three Stages of Production MPP goes negative as shown on Page 112… MPP goes negative as shown on Page 112…

23. Page 114 Three Stages of Production Why are Stage I and Stage III irrational? Why are Stage I and Stage III irrational?

24. Page 114 Three Stages of Production Productivity rising so why stop??? Output falling

25. Page 114 Three Stages of Production The question therefore is where should I operate in Stage II? The question therefore is where should I operate in Stage II?

26. Economic Dimension We need to account for the price of the product We also need to account for the cost of the inputs

27. Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Page 117-120

28. Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Average variable = total variable cost ÷ output cost Page 117-120

29. Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Average variable = total variable cost ÷ output cost Average total = total cost ÷ output cost Page 117-120

30. From TPP curve on page 113 From TPP curve on page 113 Page 118

31. Fixed costs are $100 no matter the level of production Fixed costs are $100 no matter the level of production Page 118

32. Column (2) divided by column (1) Column (2) divided by column (1) Page 118

33. Costs that vary with level of production Costs that vary with level of production

34. Page 118 Column (4) divided by column (1)

35. Page 118 Column (2) plus column (4) Column (2) plus column (4)

36. Page 118 Change in column (6) associated with a change in column (1)

37. Page 118 Column (6) divided by column (1) or Column (6) divided by column (1) or

38. Page 118 or column (3) plus column (5) or column (3) plus column (5)

39. Let’s graph the cost series in this table

40. Plotted cost relationships from table 6.3 on page 118 Plotted cost relationships from table 6.3 on page 118 Page 119 Plotting costs for levels of output

41. Now let’s assume this firm can sell its product for $45/unit

42. Key Revenue Concepts Notice the price in column (2) is identical to marginal revenue in column (7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition. Notice the price in column (2) is identical to marginal revenue in column (7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition. Page 122

43. Let’s see this in graphical form

44. Page 123 Profit maximizing level of output, where MR=MC Profit maximizing level of output, where MR=MC P=MR=AR $45 11.2

45. Page 123 Average Profit = $17, or AR – ATC Average Profit = $17, or AR – ATC P=MR=AR $45-$28 $28

46. Grey area represents total economic profit if the price is $45… Grey area represents total economic profit if the price is $45… Page 123 P=MR=AR 11.2  ($45 - $28) = $190.40

47. Zero economic profit if price falls to P BE. Firm would only produce output O BE. AR-ATC=0 Zero economic profit if price falls to P BE. Firm would only produce output O BE. AR-ATC=0 Page 123 P=MR=AR

48. Economic losses if price falls to P SD. Firm would shut down below output O SD Economic losses if price falls to P SD. Firm would shut down below output O SD Page 123 P=MR=AR

49. Where is the firm’s supply curve? Where is the firm’s supply curve? Page 123 P=MR=AR

50. Page 123 P=MR=AR Marginal cost curve above AVC curve? Marginal cost curve above AVC curve?

51. Key Revenue Concepts Page 122 The previous graph indicated that profit is maximized at 11.2 units of output, where MR ($45) equals MC ($45). This occurs between lines G and H on the table above, where at 11.2 units of output profit would be $190.40. Let’s do the math…. The previous graph indicated that profit is maximized at 11.2 units of output, where MR ($45) equals MC ($45). This occurs between lines G and H on the table above, where at 11.2 units of output profit would be $190.40. Let’s do the math….

52. Doing the math…. Produce 11.2 units of output (O MAX on p. 123) Price of product = $45.00 Total revenue = 11.2 × $45 = $504.00

53. Doing the math…. Produce 11.2 units of output Price of product = $45.00 Total revenue = 11.2 × $45 = $504.00 Average total cost at 11.2 units of output = $28 Total costs = 11.2 × $28 = $313.60 Profit = $504.00 – $313.60 = $190.40

54. Doing the math…. Produce 11.2 units of output Price of product = $45.00 Total revenue = 11.2 × $45 = $504.00 Average total cost at 11.2 units of output = $28 Total costs = 11.2 × $28 = $313.60 Profit = $504.00 – $313.60 = $190.40 Average profit = AR – ATC = $45 – $28 = $17 Profit = $17 × 11.2 = $190.40

55. Profit at Price of $45? 28 P =45 $ Q 11.2 MC ATC AVC Revenue = $45  11.2 = $504.00 Total cost = $28  11.2 = $313.60 Profit = $504.00 – $313.60 = $190.40 Since P = MR = AR Average profit = $45 – $28 = $17 Profit = $17  11.2 = $190.40 Revenue = $45  11.2 = $504.00 Total cost = $28  11.2 = $313.60 Profit = $504.00 – $313.60 = $190.40 Since P = MR = AR Average profit = $45 – $28 = $17 Profit = $17  11.2 = $190.40

56. Profit at Price of $45? 28 P =45 $ Q 11.2 MC ATC AVC Revenue = $45  11.2 = $504.00 Total cost = $28  11.2 = $313.60 Profit = $504.00 – $313.60 = $190.40 Since P = MR = AR Average profit = $45 – $28 = $17 Profit = $17  11.2 = $190.40 Revenue = $45  11.2 = $504.00 Total cost = $28  11.2 = $313.60 Profit = $504.00 – $313.60 = $190.40 Since P = MR = AR Average profit = $45 – $28 = $17 Profit = $17  11.2 = $190.40 $190.40

57. Price falls to $28.00…. Produce 10.3 units of output (O BE on p. 123) Price of product = $28.00 Total revenue = 10.3 × $28 = $288.40

58. Price falls to $28.00…. Produce 10.3 units of output Price of product = $28.00 Total revenue = 10.3 × $28 = $288.40 Average total cost at 10.3 units of output = $28 Total costs = 10.3 × $28 = $288.40 Profit = $288.40 – $288.40 = $0.00

59. Price falls to $28.00…. Produce 10.3 units of output Price of product = $28.00 Total revenue = 10.3 × $28 = $288.40 Average total cost at 10.3 units of output = $28 Total costs = 10.3 × $28 = $288.40 Profit = $288.40 – $288.40 = $0.00 Average profit = AR – ATC = $28 – $28 = $0 Profit = $0 × 10.3 = $0.00

60. Profit at Price of $28? P=28 45 $ Q 11.210.3 MC ATC AVC Revenue = $28  10.3 = $288.40 Total cost = $28  10.3 = $288.40 Profit = $288.40 – $288.40 = $0 Since P = MR = AR Average profit = $28 – $28 = $0 Profit = $0  10.3 = $0 (break even) Revenue = $28  10.3 = $288.40 Total cost = $28  10.3 = $288.40 Profit = $288.40 – $288.40 = $0 Since P = MR = AR Average profit = $28 – $28 = $0 Profit = $0  10.3 = $0 (break even)

61. Price falls to $18.00…. Produce 8.6 units of output (O SD on p. 123) Price of product = $18.00 Total revenue = 8.6 × $18 = $154.80

62. Price falls to $18.00…. Produce 8.6 units of output Price of product = $18.00 Total revenue = 8.6 × $18 = $154.80 Average total cost at 8.6 units of output = $28 Total costs = 8.6 × $28 = $240.80 Profit = $154.80 – $240.80 = – $86.00

63. Price falls to $18.00…. Produce 8.6 units of output Price of product = $18.00 Total revenue = 8.6 × $18 = $154.80 Average total cost at 8.6 units of output = $28 Total costs = 8.6 × $28 = $240.80 Profit = $154.80 – $240.80 = – $86.00 Average profit = AR – ATC = $18 – $28 = – $10 Profit = – $10 × 8.6 = – $86.00

64. Profit at Price of $18? 28 P=18 45 $ Q 11.210.38.6 MC ATC AVC Revenue = $18  8.6 = $154.80 Total cost = $28  8.6 = $240.80 Profit = $154.80 – $240.80 = $0 Since P = MR = AR Average profit = $18 – $28 = –$10 Profit = –$10  8.6 = –$86 (Loss) Revenue = $18  8.6 = $154.80 Total cost = $28  8.6 = $240.80 Profit = $154.80 – $240.80 = $0 Since P = MR = AR Average profit = $18 – $28 = –$10 Profit = –$10  8.6 = –$86 (Loss)

65. Price falls to $10.00…. Produce 7.0 units of output (below O SD on p. 123) Price of product = $10.00 Total revenue = 7.0 × $10 = $70.00

66. Price falls to $10.00…. Produce 7.0 units of output Price of product = $10.00 Total revenue = 7.0 × $10 = $70.00 Average total cost at 7.0 units of output = $28 Total costs = 7.0 × $28 = $196.00 Profit = $70.00 – $196.00 = – $126.00

67. Price falls to $10.00…. Produce 7.0 units of output Price of product = $10.00 Total revenue = 7.0 × $10 = $70.00 Average total cost at 7.0 units of output = $30 Total costs = 7.0 × $30 = $210.00 Profit = $70.00 – $210.00 = – $140.00 Average variable costs = $19 Total variable costs = $19 × 7.0 = $133.00 Revenue – variable costs = –$63.00 !!!!!

68. Profit at Price of $10? 28 P=10 18 45 $ Q 11.210.38.6 MC ATC AVC 7.0 Revenue = $10  7.0 = $70.00 Total cost = $30  7.0 = $210.00 Profit = $70.00 – $210.00 = $140.00 Since P = MR = AR Average profit = $10 – $30 = –$20 Profit = –$20  7.0 = –$140 Average variable cost = $19 Variable costs = $19  7.0 = $133.00 Revenue – variable costs = –$63 Not covering variable costs!!!!!! Revenue = $10  7.0 = $70.00 Total cost = $30  7.0 = $210.00 Profit = $70.00 – $210.00 = $140.00 Since P = MR = AR Average profit = $10 – $30 = –$20 Profit = –$20  7.0 = –$140 Average variable cost = $19 Variable costs = $19  7.0 = $133.00 Revenue – variable costs = –$63 Not covering variable costs!!!!!!

69. The Firm’s Supply Curve 28 P=10 18 45 $ Q 11.210.38.6 MC ATC AVC 7.0

70. Now let’s look at the demand for a single input: Labor

71. Key Input Relationships The following input-related derivations also play a key role in decision-making: Marginal value = marginal physical product × price product Page 124

72. Key Input Relationships The following input-related derivations also play a key role in decision-making: Marginal value = marginal physical product × price product Marginal input = wage rate, rental rate, etc. cost Page 124

73. Page 125 5 B C D E F G H I J Wage rate represents the MIC for labor Wage rate represents the MIC for labor

74. Page 125 5 B C D E F G H I J Use a variable input like labor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC Use a variable input like labor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC

75. Page 125 5 The area below the green lined MVP curve and above the green lined MIC curve represents cumulative net benefit. The area below the green lined MVP curve and above the green lined MIC curve represents cumulative net benefit. B C D E F G H I J

76. Page 125 MVP = MPP × $45

77. Page 125 Profit maximized where MVP = MIC or where MVP =$5 and MIC = $5 Profit maximized where MVP = MIC or where MVP =$5 and MIC = $5

78. Page 125 = – Marginal net benefit in column (5) is equal to MVP in column (3) minus MIC of labor in column (4) Marginal net benefit in column (5) is equal to MVP in column (3) minus MIC of labor in column (4)

79. Page 125 The cumulative net benefit in column (6) is equal to the sum of successive marginal net benefit in column (5) The cumulative net benefit in column (6) is equal to the sum of successive marginal net benefit in column (5)

80. Page 125 For example… $25.10 = $9.85 + $15.25 $58.35 = $25.10 + $33.25 For example… $25.10 = $9.85 + $15.25 $58.35 = $25.10 + $33.25

81. Page 125 = – Cumulative net benefit is maximized where MVP=MIC at $5 Cumulative net benefit is maximized where MVP=MIC at $5

82. Page 125 5 If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC. B C D E F G H I J

83. Page 125 5 If you went beyond the point where MVP=MIC, you begin incurring losses. B C D E F G H I J

84. A Final Thought One final relationship needs to be made. The level of profit-maximizing output (O MAX ) in the graph on page 123 where MR = MC corresponds directly with the variable input level (L MAX ) in the graph on page 125 where MVP = MIC. Going back to the production function on page 112, this means that: O MAX = f(L MAX | capital, land and management)

85. In Summary… Features of perfect competition Factors of production (Land, Labor, Capital and Management) Key decision rule: Profit maximized at output MR=MC Key decision rule: Profit maximized where MVP=MIC

86. Chapter 7 focuses on the choice of inputs to use and products to produce….